What Is a Reverse 1031 Exchange?

A reverse 1031 exchange lets you buy your replacement property before you sell the property you are trading away. An exchange accommodation titleholder (EAT), a company that is not you or your agent, takes title to the new property and holds it, or "parks" it, until your sale closes. Under the IRS safe harbor in Revenue Procedure 2000-37, you must identify the property you will sell within 45 days after the EAT takes title and complete the exchange within 180 days. Reverse exchanges cost more and are harder to finance than the usual sell-first exchange, because you must pay for the new property without the sale proceeds.

A safe harbor is a set of conditions under which the IRS agrees not to challenge the arrangement. For how 1031 exchanges fit with the other tax rules for property owners, see tax benefits available to homeowners.

How does a reverse exchange work?

You cannot own the new property yourself before the sale and still count it as received in the exchange, so the EAT owns it in the meantime. When the EAT parks the replacement property, the steps are:

1. Sign up with an EAT. It can hold title directly or through a single-member LLC formed for your deal. The same company can also act as your qualified intermediary for the sale; whether you need an intermediary covers how to vet one.
2. Fund the purchase. You lend or advance the money to the EAT, or guarantee a loan the EAT takes out. The safe harbor allows both.
3. The EAT closes on the replacement property. Within 5 business days after the EAT takes title, you and the EAT sign a written qualified exchange accommodation agreement. It must say the EAT holds the property for your benefit to complete a 1031 exchange and is treated as the owner for federal income tax purposes.
4. Use the property while it is parked. The EAT can lease the property to you, and you can manage it or oversee improvements.
5. Identify the property you will sell by day 45. Use the same written-notice rules as a regular exchange, and you may name alternatives.
6. Sell your old property by day 180. A qualified intermediary receives the sale proceeds and uses them to acquire the replacement property from the EAT for you. The EAT uses that money to repay your advance or the loan you guaranteed.

The safe harbor also works in the other order: the EAT can take title to the property you are giving up, you buy the replacement directly, and the EAT sells your old property to a buyer within 180 days. Either way, the combined time property is held by the EAT cannot exceed 180 days.

What are the reverse exchange deadlines?

Each deadline counts from the day the EAT receives title, not from your sale.

Plan the final closing for a business day before a weekend deadline. The IRS gives no general extension, though deadlines falling on or after a federally declared disaster can be postponed when the IRS announces relief, as how long you have to complete a 1031 exchange explains.

Two other rules decide whether the exchange works. Revenue Procedure 2004-51 bars the safe harbor if you owned the replacement property at any time in the 180 days before the EAT took title, so you cannot park property you already own, such as land you plan to build on. And if you miss a deadline, you lose the safe harbor's protection. The IRS has said parking arrangements outside the safe harbor can work, but it takes no position on them, so the result depends on the facts and the IRS may treat you as the owner of the parked property and tax the sale.

Why does a reverse exchange cost more?

• Two companies, two sets of fees. You pay the EAT to take and hold title, and a qualified intermediary to handle the sale, even when one company plays both roles. No federal rule sets these fees, so get a written fee schedule from each.
• Carrying two properties. Until the sale closes, you pay the loan, property taxes, and insurance on the new property and keep paying for the old one.
• Paying without the sale proceeds. The purchase money has to come from your cash, a loan against other property, or a loan to the EAT that you guarantee, and that money is tied up until the sale closes.
• No room for a slow sale. If the old property does not sell within 180 days, the exchange falls outside the safe harbor. You are left owning both properties, and a later sale of the old property may be fully taxable.

Why is a reverse exchange harder to finance?

While the property is parked, the EAT or its LLC holds title, not you. A purchase loan secured by the property is therefore made to the EAT, and the safe harbor lets you guarantee it personally.

Fannie Mae, which buys conventional mortgages from lenders, buys loans only when the borrowers are natural persons, with narrow exceptions for certain revocable trusts, land trusts, and renovation loans. A loan to an EAT's LLC does not fit those rules. Plan on a bank, credit union, or private lender that keeps its own loans and will lend to an EAT with your guarantee, or on paying cash and taking out a mortgage in your own name after the property is transferred to you. Ask the lender before you sign a purchase contract whether it has closed a loan to an EAT under Revenue Procedure 2000-37.

When you report the exchange, the IRS treats the property the EAT transfers to you as property received in the exchange. You file Form 8824 with your return for the year you transfer your old property, the same as in a delayed exchange; how to complete a 1031 exchange walks through the form. Both properties must still be investment or business real estate, as what a 1031 exchange is describes.